Effective Regulation - Part 3: Helping Restore Transparency

Jun 2009Source: Global Markets Institute

The third installment of our series on effective regulation

Reduce arbitrage opportunities

In the first paper of our series on effective regulation, entitled “Avoiding Another Meltdown,” we outlined key principles for improving financial regulation by reducing opportunities for financial holding companies to arbitrage regulatory and accounting standards, asset pricing, and risk controls. In this paper, we offer proposals that would help to put these principles into practice. We illustrate our ideas with simplified case studies of some key arbitrage problems, and show how our suggestions could potentially reduce them.

Strengthen controls on transfers of risk between affiliates

A serious set of problems that surfaced during the financial crisis relates to transfers of risk within financial holding companies that allowed risks to move to where they would receive favorable accounting or regulatory treatments. The range of failures and the sizeable differences in the way these issues surfaced, suggest that the problem is not so much a specific set of rules, but the generally unconstrained nature of these transfers of risk. We therefore propose that risk transfers between affiliates should be restricted so that risks flow to entities that employ full mark-to-market accounting and on-balance-sheet reporting. In essence this means that, within a financial company, risks should flow only to its investment banking arm, not away from it. Further, affiliates should not be able to subsidize investment banking businesses by offering other financial services at below market prices. This is especially important when these businesses are subsidized by government-guaranteed deposit insurance or any other government-based advantage.

Additional restrictions are appropriate for securitizations

For transactions involving asset-backed securitizations, we recommend two additional restrictions. First, securitized loans should, in aggregate, face the same capital requirements as the underlying loans would face if they were held on financial institutions’ balance sheets. Second, to qualify for regulatory capital relief, securitizations must be sold to true third parties (not to affiliates), and tranches of securitizations must be sold in equal-proportional “slices” relative to their size.

Helping to restore transparency

The current system provided significant incentives for financial companies to hold and internally transfer complex forms of risk. This made monitoring these risks challenging, and therefore made the unwind of the current crisis more difficult than it otherwise might have been. If the incentives to hold and internally transfer complex forms of risk are reduced, then financial firms will likely evolve into simpler and more transparent entities. This should make it easier, in our view, for regulators and investors alike to evaluate the health of financial firms, and would reduce the likelihood of a similar crisis.